Tuesday, September 16, 2008

Now that Lehman Brothers and Merrill Lynch have disappeared as independent investment banks over the past few days, it is time to determine whether the investment banking industry as we know it is entering a new era. The vaporization of Lehman Brothers at the point of impact of the Chicxulub subprime meteor1 and the absorption of the Thundering Herd into the gaping maw of Ken Lewis's petty cash account have left us with only two independent i-banks of any materiality, Goldman Sachs and Morgan Stanley. Those two were last seen limping around the tropical forests of southern Wyoming, so it is presumed by knowledgeable commentators that they have survived the weekend's events.

Never one to avoid a swift roll in the hay with conventional wisdom, certain elements of the chattering classes have already begun to speculate that Goldman and Morgan are not long for independence. These pundits speculate that the once-fearsome predators will be consumed by giant, lumbering herbivorous dinosaurs, some of which have been eyeing the carnivores' ecological niche covetously for, oh, about 40 million years or so. The rationale, of course, is that GS and MS will need to shelter under the protective wing of a commercial bank in order to have access to less volatile sources of funding for their huge sales and trading operations. How such unnatural inter-species combinations might be accomplished, and whether they can be done without entailing the utter destruction of one or both of the presumptive mergees—questions one might legitimately pose concerning the merger of BAC and Merrill, by the way—seem not to have attracted too much attention from these budding eugenicists.

Alternatively, there is a countervailing "Small is Beautiful" argument developing around certain other watercoolers. This crowd is yammering on about how the new order will be taken over by swarms of little furry advisory boutiques, who will survive the impending nuclear winter by sheltering in the moldering corpses of the reptilian behemoths and raise their multitudinous young on the detritus of integrated investment banks past. Certain advocates of this scenario contend that this will truly signal the end of the Age of Dinosaurs and the rise of the Age of Mammals. In contrast, others insist that, once free to run about, the little boutiquers will gradually reaggregate—like scattered globules of mercury—into great big "multi-product, multi-geography" investment banks again. Should this happen, we will likely learn that all those so-called "mammals" were really devious little reptiles in disguise, who donned fake fur and whiskers to confound hostile regulators and lawmakers while they secretly rebuilt the Age of Dinosaurs, Version 2.0.

As I am an exemplar of those few bankers who crossed the reptilian-mammalian divide into boutiqueland some years ago, I must admit that I have a predilection for the SiB-ers' position. (I know my partners and I would certainly not mind being able to pick up a passel of disgruntled former Lehmanites on the cheap.) Nevertheless, I am clear-eyed enough to know that there are many hidden forces at work in the ecological woodpile, and I could make a credible case for either of these theories, plus the as-yet unconsidered one exemplified in the status quo.

In any event, I am a realist when it comes to industry structure, not an idealist. I believe people and firms will try all sorts of ways to exploit the current market upheaval, including utilizing different (and the same old) organizational forms. As you might expect, Goldman Sachs' CFO insisted today on their earnings call that it does not want to buy a commercial bank or sell itself to one and that all is for the best in this best of all possible worlds for the Teflon Investment Bank. (Although he would have to say that, wouldn't he?) Other than plummeting stock prices, there seem to be few hints that Morgan Stanley or Goldman Sachs are not long for the planet. As far as anyone can tell, they are not insolvent or illiquid, but one could have credibly said the same about Bear Stearns or Lehman a few days before they kicked the proverbial bucket.

Only time—as I have heard it said, somewhere or other—will tell.

* * *

So how did the investment banking industry get itself into this pickle, and where does it go from here?

I must say that John Gapper of the FT—he of the permanent small furry animal hypothesis, above—does a creditable job capturing the key developments in the recent history of the industry which have led us to this pass. In his view, it was "May Day"—the elimination, in 1975, of fixed commissions for stock trades—which launched the industry onto the path of relentless growth in capital, people, and profits we have seen up until recently.

Stockbrokers such as Morgan Stanley were pushed out on their own by the 1933 Glass-Steagall Act, which enforced the separation of banks and investment banks. Their fate was probably sealed on May 1 1975, when fixed commissions for trading securities were abolished, setting off a squeeze on broking revenues.

“To stockbrokers, May Day means nothing less than the abolition of the system that has enriched them in good times and pulled many of them through during long periods of market slack,” Time magazine noted that year. Investment banks had relied on these commissions during the financial doldrums following the 1973 oil crisis.

Investment banks went on to enjoy 30 years of prosperity. They grew rapidly, taking on thousands of employees and expanding around the world. The big Wall Street firms swept through the City of London in the 1990s, picking up smaller merchant banks, such as Warburg and Schroders, on their way.

Under the surface, however, they were ratcheting up their risk-taking. It was increasingly hard to sustain themselves by selling securities – the traditional core of their business – because commissions had shrunk to fractions of a percentage point per trade. So they were forced to look elsewhere for their profits.

They started to gamble more with their own (and later others’) capital. Salomon Brothers pioneered the idea of having a proprietary trading desk that bet its own money on movements in markets at the same time as the bank bought and sold securities on behalf of its customers.

Banks insisted that their safeguards to stop inside information from their customers leaking to their proprietary traders were strong. But there was no doubt that being “in the flow” gave investment banks’ trading desks an edge. Goldman Sachs’ trading profits came to be envied by rivals.

Investment banks also expanded into the underwriting and selling of complex financial securities, such as collateralised debt obligations. They were aided by the Federal Reserve’s decision to cut US interest rates sharply after September 11 2001. That set off a boom in housing and in mortgage-related securities.

The capital markets business—securities sales and trading activities—has always been a key component of the investment banking model. Unlike the advisory side of the business, however, maintaining a credible and effective capital markets operation has always been an expensive proposition. It requires a lot of people, information technology, dedicated real estate, and other doodads that cost a lot of money to install and a lot of money to maintain. (The air conditioning bill alone to cool a trading floor full of computers on a New York summer's day would set a small Somali village up for life, for example.) In contrast, your typical M&A banker requires very little in the way of infrastructure. Outside of a nice wood-paneled conference room or two to entertain clients in, the advisory banker can usually get by with a suitcase, a cell phone, and a charter membership in the Emperors Club.

So when fixed commissions were eliminated, the huge capital markets business of a typical investment bank could no longer support itself financially. Banks needed to find another use for all that investment in infrastructure. Pace the supposed genius of the innovators at Salomon Brothers, it was only a small and intellectually undemanding step from using relatively small amounts of in-house capital to support underwriting and market-making activities to using a much larger amount of money trading for their own account, on a proprietary basis. Because they were "in the flow" and saw the securities markets from the privileged position of market makers, "prop desks" at investment banks started making money hand over fist. In other words, they started acting like hedge funds.

Add in the ballooning federal deficits of the Reagan years (and the resulting huge trading volumes in fixed income securities and related derivatives), the explosion in equity trading which accompanied the internet boom, and Alan Greenspan plying the financial markets with liquidity like a whorehouse madam plies shore-leave sailors with booze, and you can readily see that capital markets operations became the dominant business line of all major investment banks over the past couple of decades.

Of course, there was trouble in paradise. Trying to incorporate a volatile principal-oriented business like proprietary trading into an organization that was otherwise focused on agency business like M&A advisory, capital raising, and underwriting caused all sorts of problems. When the prop traders made a bundle betting for the firm, they brought home annual bonuses that struck even the highly overcompensated bankers in M&A and corporate finance as nothing short of obscene, and when their trades blew up in their faces everybody else at the firm suffered big cuts in compensation regardless of how good their individual years had been. Bankers off the trading floor began speaking bitterly about the "trader's option," while the unlucky traders got fired and sauntered across the Street to another prop desk at another bank.

For their part, the prop traders began to chafe that they were making hundreds of millions—or, occasionally, billions—for their banks but were not getting paid adequately for it. This was the genesis of Long Term Capital, which formed from a nucleus of prop traders who decamped from—you guessed it—Salomon Brothers in the mid-1990s. LTCM's fate aside, Wall Street trading desks have been the farm teams for serious hedge fund traders ever since.

The compensation systems at investment banks could not deal with this development, either. Proprietary traders, CDO structurers, and derivatives specialists began taking and holding positions with longer and longer risk tails, but still got measured and paid based on systems designed to measure the annual production of a banker conducting traditional agency business, like M&A or equity underwriting. Imbalances built up, risk and return became misaligned, and various pieces of shit began hitting various fans. Paying traders, corporate financiers, and M&A advisors with long-vesting restricted stock did create some sort of alignment with the firm's and shareholders' interests, but it was too blunt an instrument to contain and control the stresses building up in the new hybrid hedge fund-investment banking model.

You know the rest of the story.

* * *

Now the cleverer among you might have already questioned why the investment banks didn't simply abandon the securities sales and trading business when it became unprofitable after May 1975. There are three reasons, two of which are relatively trivial, but one of which goes to the heart of the question of what will happen to the industry business model going forward.

For one thing, commissions did not vanish in one fell swoop after May 1, 1975. Competition was introduced, and commissions shrank gradually over a number of years. Investment banks did not necessarily see the writing on the wall for quite some time, and by the time they realized that pure agency capital markets was now and forever a loss leader business, it was in many respects too late to change. (Gimlet-eyed financial entities or not, investment banks are subject to the same irrational commitment to sunk costs and legacy businesses as our friends in the real industrial economy.) Second, capital markets businesses were always large, controlling roughly half the resources of a typical investment bank and sometimes more. Human psychology and organizational theory tell us that it is very difficult to kill a business line with so much human, psychological, and political capital committed to it, plus sharp-elbowed leaders who are committed to fight for it.

But most importantly—and perhaps surprisingly—the capital markets business has always been an integral part of an investment bank's advisory business. This may be obvious for corporate finance activities like selling bonds to raise capital for a railroad or underwriting an initial public stock offering for a technology company. Raising capital for corporate clients has always been an extremely important business line for investment banks. In fact, it was really the only business investment banks conducted for many years after their separation from commercial banks in the 1930s after Glass-Steagall, until the emergence of a new business in the late 1970s which came to be known as mergers and acquisitions advisory. All those "client bankers" to Ford Motor Company, CSX Corporation, and Netscape did and do rely heavily on their buddies on the capital markets desk to gauge investor demand, structure attractive security offerings, and help sell their clients' securities to new investors.

But what is really interesting is that M&A bankers rely heavily and often on their capital markets colleagues, too. I am not speaking, by the way, of private equity-led buyouts, where M&A bankers get dragged along to "advise" the PE clients in name only. In such deals, the PE firms hire "financial advisors" solely for their prowess and ability to raise leveraged finance to fund transactions, not for any putative real advice from an industry or M&A banker. The private equity guys couldn't care less what some guy like me has to say. They just want the money.

But in the case of corporate clients, there is all sorts of useful intelligence an M&A banker can glean from his capital markets partners which bears directly on the approach, feasibility, and potential price of doing a deal. There are shareholder and bondholder lists to parse, market chatter to channel, and potential financing terms to suss out. Publicly traded corporations want to know how the markets will react to the announcement of a transaction, and CEOs want to know who are the top 20 critical investors they should talk to to explain the rationale for selling a division or buying their biggest competitor. Once the deal is announced, the capital markets bankers become the client's direct channel to Mr. Market, with all the positive and negative feedback that entails. This is real-time information, of the most critical kind, filtered with skill and intelligence by people who know what the hell they are talking about. There is no better definition of market-based advice, and no better example of the type of added value an integrated investment bank can bring to its client.

Not all clients need or value this type of advice, so independent pure advisory firms like Greenhill, Evercore, and the like can survive and even prosper on M&A business alone. But an important number of companies do, and such companies form a durable and defensible client base for integrated investment banks which can deliver such capabilities. Not to mention that Goldman, Morgan, and even the Frankenstein hybrids of universal banks like Citigroup, JP Morgan, and Deutsche Bank have the leveraged finance capability to deliver deal funding to private equity buyers and other financial derelicts in need of other peoples' money.

Pure advisory boutiques cannot deliver this sort of advice, because they do not have the capital markets arms to deliver it. But capital markets operations of any consequence (i.e., those which can deliver good market intelligence) are too expensive to support solely with the revenues a successful M&A practice brings in. Here is your Catch-22, if you like. Advisory practices cannot compete with fully integrated investment banks in all situations without capital markets capabilities, but capital markets capabilities cannot pay for themselves without proprietary trading operations. We seem to be stuck with the integrated i-bank model, whether we like it or not.

* * *

"So what the fuck is your conclusion, TED?," you think to yourself. Good question.

If I had to venture a guess—you didn't think I wouldn't, did you?—I would say that we will see a repopulation of the middle of the industry over time. At the top end, in size and revenues—but not necessarily prestige or reputation—we will continue to see hedge fund-i-bank hybrids flinging their balance sheets about and trying to be all things to all people. Most of these will be combinations of commercial banks and investment banks, but there may still be a place for a Goldman Sachs or a Morgan Stanley if they remain religiously devoted to careful risk control.

Such firms should be successful, at least among the clients who truly need the services they deliver. The current market environment, and the current systemwide flight from risk, may mean that these banks will have to settle for lower returns on equity, and their bankers will have to settle for lower compensation, than they have been used to in the recent past. If this is the case, you will see higher-profile investment bankers—"rainmakers" who can write their own ticket (or persuade others they can)—bleed out of such leviathans into smaller, more prestigious advisory boutiques, where they can eat what they kill.

You may see some independent boutiques grow in size, and become credible competitors to Lazard and the in-house M&A factories of larger banks. But for this to happen, we will need to see an institutionalization of advisory boutiques which has been lacking to date. So far, the named boutiques we read about all depend on one or two serious, named founders who generate all the revenue, and a bunch of lesser-known, competent bankers who carry their bags. For boutiques to truly thrive and prosper, you will need to see firms that can field 10, 20, or even 50 senior partners who can slug it out toe-to-toe with the best that Goldman, Citigroup, or JP Morgan can offer. And you will need to read about them in the pages of Institutional Investor and The Wall Street Journal.

Where this leaves me, and where I fit into this picture, I prefer not to say. But I will say that I expect the next several years to be very interesting ones for the investment banking industry.

Fasten your seat belts, comrades.

1 Or its absorption into the gaping maw of Bob Diamond's petty cash account. It matters not: the result is the same. You should know, Dear Readers, that I have never been willing to sacrifice an entertaining metaphor for the trite and uninspiring vagaries of the truth.